Does Buttonwood persist in error?

Baruch is getting schtick in the comments for a now mildly embarrassing post he wrote at the high tide of equities in 2007, criticising the Economist’s now not totally un-prescient looking Buttonwood column. Reader John goes so far as to suggest that Baruch now looks like a “jackass”. Reader Anish, finding it hard to avoid exclamation marks, says he hates “rubbing it in” and of course proceeds to do just that.

While there are some fist-bitingly cringeworthy bits, the substantive points Baruch was making at the time, viz perma bears are not normally useful, and that the Economist has an especially dreadful record in giving stockmarket advice, still hold water, I think. I wrote of the

tendency of commentators who are Obviously Clever to be negative about the stockmarket, and how in this they are generally completely wrong, at best, or at worst simply confusing. It’s not as if you can use them as contra-indicators because sometimes, just often enough to keep them in business, the stockmarket actually does go down

(emphasis added post hoc, or is it hic). I would say similar things about perma-bulls, like Larry Kudlow, as well. But readers like Anish and John, no doubt open, trusting, simplistic creatures seeking guidance, only see the track record of the last 18 months. They compare Baruch’s inability to forecast the last downturn to Buttonwood’s annoyingly accurate diagnoses of what was going to happen, and find him wanting. Buttonwood 1, Baruch 0, they think. Well, it’s not unfair. In Baruch’s defence he can only argue that he was a fast follower, and 2 months after bashing Buttonwood joined him in becoming all miserably bearish as well. At least in print.

However, recent Buttonwood columns have made at least two points that are wrongly used in support of a continued bear market. Firstly positive feedback loops in bull markets, Buttonwood claims, can go into reverse in bear markets and prolong them “with devastating effect”, just as they helped sustain the bull. One mechanism is rising tax rates, as government deficits grow. Another is company pension funds going into deficit, forcing companies to top them up, further draining cashflow. It’s not as simple as that actually, as the discount rates used to calculate pension obligations often fall with interest rates, but I will stop here as there is nothing more tedious than calculating pension obligations. We can go with Buttonwood on this one too.

The other mechanism that prolongs bear markets, according to Buttonwood, Citigroup and a study by something called Smithers & Co, is a change in the supply-demand for equity paper; bear markets see the end of many company buy back programmes, and the need to raise equity capital to refinance stressed balance sheets reduces the demand for equity while increasing its supply. Doom follows, naturally enough. There are 3 good reasons for thinking this is totally wrong:

Buttonwood completely ignores the real impact of buybacks, in the US at least, which is more often than not to cover up the shares companies are issuing in share options. I never tire of the example of Qualcomm in 2006, which bought back $2.7 billion worth of its shares, 4% or so of its market cap, almost all their $2.8bn pro forma profit that year. And their share count went up! Up! By 0.4% that year. Never mind the appalling conclusion that if we count share options as an integral part of compensation, as we should, most of corporate America actually makes only a fraction of the actual economic return it reports; for us it is enough to note that the massive issuance of share options in the bull market of 2002-2007 dishes Buttonwood’s point about self-reinforcing loops in bull markets. Share prices going up creates more shares as options move into the money and vest, ie it increases supply at the height of bull markets. In bear markets, more options are worthless and fewer shares are issued, but the remaining share buybacks coming from companies with still-well-capitalised balance sheets are more effective and supply is reduced. Rather than being a positive feedback loop reinforcing the direction of the market, the nexus between issuance and buybacks is more likely to work in reverse, ie have a stabilising influence.

IPOs and all stock M&A: Buttonwood doesn’t mention IPOs. Pets.com doesn’t come to market at the bottom of the cycle, rather at the top. That’s an anti-cyclical source of supply. M&A is another. Throughout the cycle, cash M&A deals work to reduce supply of stocks as the stock of the acquired company is removed from circulation. In all share deals no equity is removed. We tend to see all stock deals, and overpriced ones at that, at market tops, and all cash deals, which takes equity out of supply, at the bottom.

Rights issues and recapitalisations of stressed balance sheets through new equity, thinks Buttonwood, quoting Citigroup’s Robert Buckland, “soaks up money that might otherwise have been used to drive the market higher”. Wrong! Have they seen the secondaries recently? They’ve been great! Almost all of them have worked (and we’ve had a lot of them), and the stock concerned has gone up from the pricing. Recapitalising a stressed balance sheet at the bottom of a bear market is an incredibly bullish thing, not a bearish one. Done properly it means the company is more likely to survive than not, and this is a multiple expander. Baldly put, Buttonwood is suggesting that repairing balance sheets makes the stockmarket go down. One can only believe this if one takes as one’s starting point that fundamentals don’t matter. This Baruch can never do!

The second bearish point is made in this week’s Buttonwood column, looking at the recent big spike in US 10 year bond yields, and gives it the most negative spin possible, that it means a higher chance of inflation, dollar decline and loss of reserve status. Buttonwood agrees with the proposition that “the American government is now the most serious source of systemic risk.” Me, well, I think that’s probably right, but I couldn’t help thinking when I saw the move in the 10 year, oh good, less risk aversion! Fact is, I have been more worried about deflation than anything else. A deflationary environment is marked by lower stock prices and extremely low bond yields, may I refer the right honourable reader to Japan. Selling the 10 year implies the Japan syndrome is being taken off the table. This is extremely positive for equities, which have always been seen as an excellent inflation hedge. Sure, we may be (OK, are) heading for a problem with excessive government deficits. There’s even the possibility of some sort of issue with China, whose nest egg, after all, has been largely invested in US treasury debt. But were I given the choice between that and a debt deflation cycle, I would not hesitate; the rise in yields is good news, not bad. It is what we have to see for us to recover.

Look, I know things aren’t fixed yet; we’re up 30% from the lows in what looks like a classic bear market bounce. As Cassandra tells us these suck us in and convert us before they blow up in our faces. There are still forces for instability at work. But the difference is now that they have been joined by reasons for optimism which weren’t there before. Whether they are in the price or not I don’t know. But the factors influencing demand and supply given here by Buttonwood as reasons for continued pessimism, clever chap that she is, are not the ones that are going to “get us”, I think. And if we get thwacked by the US deficit, I don’t think it can be as bad as what we went through already. In the battle between the Great Unwind and the Great Reflation, I think it is round one to Reflation. I may have a shorter timeframe (something like 3 months at the moment), but I can’t have Buttonwood’s apparent certainty that it is about to end badly yet.

Why do I pick on Buttonwood so? Because I worry he may be a perma-bear, albeit at the smarter end of the spectrum. Just as the main function of the Jimmy Glassmans and Larry Kudlows of the world is to have you run full speed into looming brick walls, so the job of the perma-bear (and The Economist), is to keep you from having any fun whatsoever. He keeps you out of the boom times, which are the only periods in which most investors can make any serious money. Inculcating fear and shame are the goals of the perma-bear; fear of imminent calamity, and a sort of Calvinist guilt that riding stockmarket rises are somehow immoral and lack intellectual bottom. The tool they use is first-order lumping, as if they were arguing a brief. Friendly data is quoted approvingly and left unexamined; neutral data is spun negatively, any potential positive implications poo-poohed; and unfriendly data is taken to bits. If no flaw can be found it has to be ignored.

This is woolly thinking, and Baruch has a knee-jerk reaction when he sees it. If Buttonwood is not him- or herself guilty of this, Baruch apologises. But certainly many fellow travellers are, and it must be resisted.